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Bridge over ocean
1 January 1992 Financial Analysts Journal Volume 48, Issue 1

What Practitioners Need to Know…About Option Replication

  1. Mark P. Kritzman, CFA

A financial option gives the owner the right to buy (in the case of a call option) or to sell (in the case of a put option) an asset at a specified price. This right, in the case of an American option, can be exercised at any time over a specified period. (A European option can be exercised only at a specific date.) Exchange traded options are available on a large variety of individual securities, as well as on stock indexes, dollar denominated foreign currencies and futures contracts.

Despite the wide availability of exchange traded options, the demand for option like payoffs vastly exceeds the supply. A large market in privately negotiated options and in option replication strategies has emerged. This generates option like results for assets or portfolios on which exchange traded options are not available or for terms different from the typical terms of exchange traded options. This column demonstrates how we can generate an option like payoff by shifting a fund between two assets.

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